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Fixing the Financial System

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The first session of the FCIC bank hearings yesterday — the one where Phil Angelides got to grill bank CEOs — is the one that got all the attention, but Mike Konczal says the second session was actually more interesting. That was the one where a group of three financial industry experts were able to talk plainly and simply about what needs to happen going forward:

The three panelists gave very specific ideas about where reform needs to take place to get our financial sector back on track. The first key is bank leverage, how much money they lend for how much they keep in pocket. The higher this ratio, the more risky their firm is.

Right now you can qualify as minimally leveraged at 25-to-1, which means you lend out $25 for every $1 you actually own, which is unmanageable according to the participants. These ratios need to come down for the largest firms. Fannie-Freddie are even worse; the participants claimed that they had a 95-to-1 leverage at one point (just 18 basis points of capital), a monstrously risky number for any firm, much less a large one.

What about Glass-Steagall, the New Deal law that split up investment banking from commerical banking? There was disagreement among the participants, with a general agreement that it should be updated for the capital markets of the 21st century. Banks that are diversified with both commercial and investment wings survived better than normal investment banks, an argument that the deregulation was successful. However this leaves a situation where the Federal Discount window, the safety net the Federal Reserve provides banks to avoid disastrous bank runs, is being used to fund high-risk hedge fund like proprietary trading operations. So the suggestion is to update Glass-Steagall for the 21st century where risky operations are silo’ed away from normal operations.

….While discussing the over the counter derivatives market with Brooksley Born, it was clear that derivatives reform was one of the most necessary items. Derivatives need to clear on a central exchange, with a data repository. Solomon predicted the price of derivatives would fall quickly, in the same way that stock commissions fell back when regulation was brought to that market on the so-called “May Day.” This is why banks, who keep this money from bespoke derivatives, want to derail this without getting too many fingerprints on it.

Regular readers know that I think this is basically right. Leverage is far and away the key issue: put in place a set of simple rules that regulate leverage to sensible levels; regulate it everywhere, not just within banks themselves; and regulate it in all its various forms. If we did that and accomplished nothing else, I’d consider regulatory reform a qualified success.

Beyond that, regulating derivatives is more important than repealing Glass-Steagall. I like the idea of firewalling risky securities trading away from core banking functions, but I’m basically not convinced that repealing Glass-Steagall was a key cause of the banking crisis. After all, some commercial banks did fine and some failed. Some investment banks did OK and some failed. Some merged superbanks did fine and some failed. It’s pretty hard to find a thread there. However, the combination of the repeal with the 2000 passage of the Commodity Futures Trading Act, which kept derivatives unregulated and turned huge Wall Street banks into casinos, was disastrous. So yes: put in place a firewall, and pay particular attention to regulating derivatives. The housing bubble could still have happened without them, but it was the derivatives market that supercharged it.

And that would be the ballgame. Sure, there are other aspects of regulatory reform that I’d like to see enacted, but serious leverage limitations alone would make reform a qualified success, and the addition of serious derivative regulation would make it a historic success. I’d pretty much trade everything else away if I could get just that.

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